The Classical Background

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1 The Classical Background“Classical Economics” s: Adam Smith, David Ricardo, J. S. MillConcerned with issues of long run growth and of maintaining growthConsequences of growth for distribution of incomePolicy concern with removing barriers to growth created by unwise government legislation

2 Major Components of Classical EconomicsTheory of exchange value based on labour time or cost of production.Water diamond paradox; use values not comparable.Theory of Natural and Market Price and adjustment to Natural PriceWage Fund Theory of Labour DemandPopulation theory of labour supply and the subsistence wage

3 Major Components of Classical EconomicsTheory of Rent and diminishing returns in agricultureRicardo’s corn model of falling rate of profit and eventual stationary stateSay’s LawTendency to equilibrium at full employmentMonetary factors as disturbing causesTheory of gains from tradeComparative advantageTerms of trade

4 Challenges to Classicism: Internal WeaknessesTheory of exchange valueProblems of cost side theoriesJ. S. Mill—cost of production of the most costly portionWage Fund TheoryJ. S. Mill’s “recantation” of the wage fund theoryNew IssuesEconomies of scale and growth of industryBusiness Cycles

5 Challenges to Classicism: German HistoricismReaction against the non-historical nature of Ricardian economicsDifferent principles apply to different times and placesEvolutionary and theories of economic stagesOrganic analogiesImportance of institutions, law, and ethics

6 German Historicism National policy and role of the stateHistoricism a major influence in Germany, America, and to a lesser extent in EnglandHistoricism was a major influence from sEconomic History, empirical studies, social reform

7 Challenges to Classicism: MarxismMarx used the labour theory of value to argue that profit came from the exploitation of labourLabour was paid less than the value of its outputElements of Classical economics used to cast a very negative light on capitalismMarxism became influential in the 1880s, Socialist parties, labour unrest

8 Challenges to Classicism: RomanticismThe “romantic” critics of economics included Carlye and RuskinSaw economics as concerned only with material ends and not with anything “higher” or more spiritual--a narrow economic manConcerned only with market valuationsCarlye and Mill and the “dismal science”

9 New Techniques: Forerunners of the Marginal RevolutionMarginalist ideas and analysis were being developed in Europe well before 1870 and the Marginal RevolutionDaniel Bernoulli ( )Diminishing MU of income and the analysis of expected utilityWilliam Gossen ( )Gossen’s “First Law”: law of satiable wants. Implies diminishing MUGossen’s “Second Law” conditions for a utility maximum

10 Forerunners of the Marginal Revolution: DupuitJules Dupuit ( )Measurement of the utility of public worksDifferent people have different valuations of a goodWillingness to pay and consumer’s surplusSetting of tolls to finance public utilities

12 Forerunners of the Marginal Revolution: CournotAugustin Cournot ( )Early pioneer of the mathematical approachLaw of demand expressed as a general mathematical function: D=F(P)D varies inversely with PContinuous functionAnalysis of monopoly, marginal revenue and profit maximization

13 Cournot Cournot’s analysis of duopolyEach firm sets an output given the output of the otherReaction functions leading to an equilibriumCournot equilibrium is where each firm is doing the best it can given the other firm’s outputExample of two mineral springs with zero production costsMarket demand function P=100-Y where Y is total output of both firmsProfit for firm 1 = PxQ1or Q1(100-Q1-Q2)Profit for firm 2 = Q2(100-Q1-Q2)

14 CournotP10050MRD50100Monopoly solution: Q1=50; P=50; Profit=250If second firm enters and takes Q1 as givenIt will produce where it max Q2( Q2)Which is at Q2=25.Given Q2=25 firm 1 will adjust in order to maxQ1(100-Q1-25)= 37.5These reactions continue until an equilibrium isreached

16 Reasons for the Marginal RevolutionDecay of Classical economicsNew techniques of marginal analysisAn answer to RomanticismUtility maximization can accommodate ends other than purely material onesAn answer to HistoricismMenger and the “Methodenstreit”An answer to MarxMarginal productivity theoryAnalogy to physics and use of calculus